MANAGERIAL ECONOMICS

Managerial Economics can be defined as amalgamation of economic theory with business practices so as to ease decision-making and future planning by management. Managerial Economics assists the managers of a firm in a rational solution of obstacles faced in the firm’s activities. It makes use of economic theory and concepts. It helps in formulating logical managerial decisions. The key of Managerial Economics is the micro-economic theory of the firm. It lessens the gap between economics in theory and economics in practice. Managerial Economics is a science dealing with effective use of scarce resources. It guides the managers in taking decisions relating to the firm’s customers, competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical and analytical tools to assess economic theories in solving practical business problems.

Study of Managerial Economics helps in enhancement of analytical skills, assists in rational configuration as well as solution of problems. While microeconomics is the study of decisions made regarding the allocation of resources and prices of goods and services, macroeconomics is the field of economics that studies the behavior of the economy as a whole (i.e. entire industries and economies). Managerial Economics applies micro-economic tools to make business decisions. It deals with a firm.

The use of Managerial Economics is not limited to profit-making firms and organizations. But it can also be used to help in decision-making process of non-profit organizations (hospitals, educational institutions, etc). It enables optimum utilization of scarce resources in such organizations as well as helps in achieving the goals in most efficient manner. Managerial Economics is of great help in price analysis, production analysis, capital budgeting, risk analysis and determination of demand.

Managerial economics uses both Economic theory as well as Econometrics for rational managerial decision making. Econometrics is defined as use of statistical tools for assessing economic theories by empirically measuring relationship between economic variables. It uses factual data for solution of economic problems. Managerial Economics is associated with the economic theory which constitutes “Theory of Firm”. Theory of firm states that the primary aim of the firm is to maximize wealth. Decision making in managerial economics generally involves establishment of firm’s objectives, identification of problems involved in achievement of those objectives, development of various alternative solutions, selection of best alternative and finally implementation of the decision.

The following figure tells the primary ways in which Managerial Economics correlates to managerial decision-making.

Scope of Managerial Economics

Managerial Economics deals with allocating the scarce resources in a manner that minimizes the cost. As we have already discussed, Managerial Economics is different from microeconomics and macro-economics. Managerial Economics has a more narrow scope - it is actually solving managerial issues using micro-economics. Wherever there are scarce resources, managerial economics ensures that managers make effective and efficient decisions concerning customers, suppliers, competitors as well as within an organization. The fact of scarcity of resources gives rise to three fundamental questions-

1. What to produce?
2. How to produce?
3. For whom to produce?

To answer these questions, a firm makes use of managerial economics principles

The first question relates to what goods and services should be produced and in what amount/quantities. The managers use demand theory for deciding this. The demand theory examines consumer behaviour with respect to the kind of purchases they would like to make currently and in future; the factors influencing purchase and consumption of a specific good or service; the impact of change in these factors on the demand of that specific good or service; and the goods or services which consumers might not purchase and consume in future. In order to decide the amount of goods and services to be produced, the managers use methods of demand forecasting.

The second question relates to how to produce goods and services. The firm has now to choose among different alternative techniques of production. It has to make decision regarding purchase of raw materials, capital equipments, manpower, etc. The managers can use various managerial economics tools such as production and cost analysis (for hiring and acquiring of inputs), project appraisal methods( for long term investment decisions),etc for making these crucial decisions.

The third question is regarding who should consume and claim the goods and services produced by the firm. The firm, for instance, must decide which is it’s niche market-domestic or foreign? It must segment the market. It must conduct a thorough analysis of market structure and thus take price and output decisions depending upon the type of market.

Managerial economics helps in decision-making as it involves logical thinking. Moreover, by studying simple models, managers can deal with more complex and practical situations. Also, a general approach is implemented. Managerial Economics take a wider picture of firm, i.e., it deals with questions such as what is a firm, what are the firm’s objectives, and what forces push the firm towards profit and away from profit. In short, managerial economics emphasizes upon the firm, the decisions relating to individual firms and the environment in which the firm operates. It deals with key issues such as what conditions favour entry and exit of firms in market, why are people paid well in some jobs and not so well in other jobs, etc. Managerial Economics is a great rational and analytical tool.

Managerial Economics is not only applicable to profit-making business organizations, but also to non- profit organizations such as hospitals, schools, government agencies, etc.

Nature of Managerial Economics

Managers study managerial economics because it gives them insight to reign the functioning of the organization. If manager uses the principles applicable to economic behaviour in a reasonably, then it will result in smooth functioning of the organisation.

Managerial Economics is a Science

Managerial Economics is an essential scholastic field. It can be compared to science in a sense that it fulfils the criteria of being a science in following sense:

• Science is a Systematic body of Knowledge. It is based on the methodical observation. Managerial economics is also a science of making decisions with regard to scarce resources with alternative applications. It is a body of knowledge that determines or observes the internal and external environment for decision making.

• In science any conclusion is arrived at after continuous experimentation. In Managerial economics also policies are made after persistent testing and trailing. Though economic environment consists of human variable, which is unpredictable, thus the policies made are not rigid. Managerial economist takes decisions by utilizing his valuable past experience and observations.
• Science principles are universally applicable. Similarly policies of Managerial economics are also universally applicable partially if not fully. The policies need to be changed from time to time depending on the situation and attitude of individuals to those particular situations. Policies are applicable universally but modifications are required periodically.

Managerial Economics requires Art

Managerial economist is required to have an art of utilising his capability, knowledge and understanding to achieve the organizational objective. Managerial economist should have an art to put in practice his theoretical knowledge regarding elements of economic environment.

Managerial Economics for administration of organization

Managerial economics helps the management in decision making. These decisions are based on the economic rationale and are valid in the existing economic environment.

Managerial economics is helpful in optimum resource allocation

The resources are scarce with alternative uses. Managers need to use these limited resources optimally. Each resource has several uses. It is manager who decides with his knowledge of economics that which one is the preeminent use of the resource.

Managerial Economics has components of micro economics

Managers study and manage the internal environment of the organization and work for the profitable and long-term functioning of the organization. This aspect refers to the micro economics study. The managerial economics deals with the problems faced by the individual organization such as main objective of the organization, demand for its product, price and output determination of the organization, available substitute and complimentary goods, supply of inputs and raw material, target or prospective consumers of its products etc.

Managerial Economics has components of macro economics

None of the organization works in isolation. They are affected by the external environment of the economy in which it operates such as government policies, general price level, income and employment levels in the economy, stage of business cycle in which economy is operating, exchange rate, balance of payment, general expenditure, saving and investment patterns of the consumers, market conditions etc. These aspects are related to macro economics.

Managerial Economics is dynamic in nature

Managerial Economics deals with human-beings (i.e. human resource, consumers, producers etc.). The nature and attitude differs from person to person. Thus to cope up with dynamism and vitality managerial economics also changes itself over a period of time

Managerial Economics and Micro Economics

Managerial Economics is basically a blend of Economics and Management. Two branches of economics i.e. micro economics and macro economics are the major contributors to managerial economics.

Micro Economics is the study of the behaviour of individual consumers and firms whereas microeconomics is the study of economy as a whole.

Managerial Economics and Micro Economics

All the firms operating in the market have to take under consideration the constituent of the economic environment for its proper functioning. This economic environment is nothing but the Micro economics elements.

Micro Economics is a broader concept as compare to Managerial Economics. Micro Economics forms the foundation of managerial economics. Almost all the concepts of Managerial Economics are the perceptions of Micro Economics concepts.

Managerial economics can be perceived as an applied Micro Economics. Demand Analysis and Forecasting, Theory of Price, Theory of Revenue and Cost, Theory of Supply and Production are major bare bones of Micro Economics that underpins the Managerial Economics. Managerial Economics applies the theories of Micro Economics to resolve the issues of the organization and for decision making.

All Managers want to carry out their function of decision making with maximum efficiency. Their business planning can be effectively planned and performed with comprehensive knowledge and understanding of micro economic concept and its applications. Optimum decision making to achieve the objective of the organisation i.e. for profit maximizing or for cost minimizing, is possible with proper compliance of micro economic know how, regardless of the technological constraints and given market conditions. Micro Economic Analysis is important as it is applied to day to day dilemma and concerns.

The reliance of Managerial Economics on Micro Economics is made clearer in the points below:

• If a manager wants to increase the price of the product due to increase in cost of production, he will analyze the price elasticity of demand for that product so that price rise is not followed by substantial fall in the demand of the product. It is the application of demand analysis to the real world situation.
• For fixing the price of the products managers applies the pricing theories, cost and revenue theories of micro economics.
• Decisions regarding production and supply of the product in the market, knowledge of availability of fixed and variable factors of production, state of technology to be used and availability of raw-material are essential. This can be determined with the knowledge of theory of production.
• Determination of price and output is possible with the acquaintance of market structures and approaches pertinent for determination of price and output in the given market setup.
• Managerial economics utilizes statistical methods such as game theory, linear programming etc for application of Economic Theory in Decision making.
• One of the responsibilities of Manager is to workout budgets for different departments of the organization which is learned from Capital Budgeting and Capital Rationing.
• Cost and benefit analysis helps the manager in decision making.
• Study of welfare economics helps Manager in taking care of social responsibilities of the organization.
• Microeconomics is the study that deals with partial equilibrium analysis which is useful for the manager in deciding equilibrium for his organization.
• Managerial Economics also uses tools of Mathematical Economics and econometrics such as regression analysis, correlation analysis etc.
• Theory of firm, an important element of microeconomics, is one of the most significant element of Managerial Economics.

Principles of Managerial Economics

Economic principles assist in rational reasoning and defined thinking. They develop logical ability and strength of a manager. Some important principles of managerial economics are:

1. 
   

Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the firm’s objective of profit maximization, it leads to increase in profit, which is in either of two scenarios-

• If total revenue increases more than total cost.
• If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable on the other. Marginal generally refers to small changes. Marginal revenue is change in total revenue per unit change in output sold. Marginal cost refers to change in total costs per unit change in output produced (While incremental cost refers to change in total costs due to change in total output). The decision of a firm to change the price would depend upon the resulting impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the change in price.

Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's performance for a given managerial decision, whereas marginal analysis often is generated by a change in outputs or inputs. Incremental analysis is generalization of marginal concept. It refers to changes in cost and revenue due to a policy change. For example - adding a new business, buying new inputs, processing products, etc. Change in output due to change in process, product or investment is considered as incremental change. Incremental principle states that a decision is profitable if revenue increases more than costs; if costs reduce more than revenues; if increase in some revenues is more than decrease in others; and if decrease in some costs is greater than increase in others.

2. Equi-marginal Principle

   Marginal Utility is the utility derived from the additional unit of a commodity consumed. The laws of equi-marginal utility states that a consumer will reach the stage of equilibrium when the marginal utilities of various commodities he consumes are equal. According to the modern economists, this law has been formulated in form of law of proportional marginal utility. It states that the consumer will spend his money-income on different goods in such a way that the marginal utility of each good is proportional to its price, i.e.,
   MUx / Px = MUy / Py = MUz / Pz
   Where, MU represents marginal utility and P is the price of good.
   Similarly, a producer who wants to maximize profit (or reach equilibrium) will use the technique of production which satisfies the following condition:
   MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
   Where, MRP is marginal revenue product of inputs and MC represents marginal cost.
   Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes the ratio of marginal returns and marginal costs of various use of resources in a specific use.

3. Opportunity Cost Principle

   By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If there are no sacrifices, there is no cost. According to Opportunity cost principle, a firm can hire a factor of production if and only if that factor earns a reward in that occupation/job equal or greater than it’s opportunity cost. Opportunity cost is the minimum price that would be necessary to retain a factor-service in it’s given use. It is also defined as the cost of sacrificed alternatives. For instance, a person chooses to forgo his present lucrative job which offers him Rs.50000 per month, and organizes his own business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business.

4. Time Perspective Principle

   According to this principle, a manger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions, giving apt significance to the different time periods before reaching any decision. Short-run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long-run is a time period in which all factors of production can become variable. Entry and exit of seller firms can take place easily. From consumers point of view, short-run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long-run is a time period in which the consumers have enough time to respond to price changes by varying their tastes and preferences.

5. Discounting Principle

   According to this principle, if a decision affects costs and revenues in long-run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present dollars. For instance, $1 invested today at 10% interest is equivalent to $1.10 next year.
   FV = PV*(1+r)^t
   Where, FV is the future value (time at some future time), PV is the present value (value at t0, r is the discount (interest) rate, and t is the time between the future value and present value.
   
   

   Consumer Demand 

   
   

   What is Demand?

   Demand for a commodity refers to the quantity of the commodity that people are willing to purchase at a specific price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising, etc) being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it and sufficient purchasing power to purchase it. For instance-Everyone might have willingness to buy “Mercedes-S class” but only a few have the ability to pay for it. Thus, everyone cannot be said to have a demand for the car “Mercedes-s Class”.

   Demand may arise from individuals, household and market. When goods are demanded by individuals (for instance-clothes, shoes), it is called as individual demand. Goods demanded by household constitute household demand (for instance-demand for house, washing machine). Demand for a commodity by all individuals/households in the market in total constitute market demand.

   Demand Function

   Demand function is a mathematical function showing relationship between the quantity demanded of a commodity and the factors influencing demand.

   Dx = f (Px, Py, T, Y, A, Pp, Ep, U)

   In the above equation,
   Dx = Quantity demanded of a commodity
   Px = Price of the commodity
   Py = Price of related goods
   T = Tastes and preferences of consumer
   Y = Income level
   A = Advertising and promotional activities
   Pp = Population (Size of the market)
   Ep = Consumer’s expectations about future prices
   U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy, availability of credit facilities, etc.

   Law of Demand

   The law of demand states that there is an inverse relationship between quantity demanded of a commodity and it’s price, other factors being constant. In other words, higher the price, lower the demand and vice versa, other things remaining constant.

   Demand Schedule

   Demand schedule is a tabular representation of the quantity demanded of a commodity at various prices. For instance, there are four buyers of apples in the market, namely A, B, C and D.

   Demand schedule for apples

   PRICE (Rs. per dozen)	Buyer A (demand in dozen)	Buyer B (demand in dozen)	Buyer C (demand in dozen)	Buyer D (demand in dozen)	Market Demand (dozens)
   10	1	0	3	0	4
   9	3	1	6	4	14
   8	7	2	9	7	25
   7	11	4	12	10	37
   6	13	6	14	12	45

   The demand by Buyers A, B, C and D are individual demands. Total demand by the four buyers is market demand. Therefore, the total market demand is derived by summing up the quantity demanded of a commodity by all buyers at each price.

   Demand Curve

   Demand curve is a diagrammatic representation of demand schedule. It is a graphical representation of price- quantity relationship. Individual demand curve shows the highest price which an individual is willing to pay for different quantities of the commodity. While, each point on the market demand curve depicts the maximum quantity of the commodity which all consumers taken together would be willing to buy at each level of price, under given demand conditions.

   

   Demand curve has a negative slope, i.e, it slopes downwards from left to right depicting that with increase in price, quantity demanded falls and vice versa. The reasons for a downward sloping demand curve can be explained as follows-

   1. Income effect- With the fall in price of a commodity, the purchasing power of consumer increases. Thus, he can buy same quantity of commodity with less money or he can purchase greater quantities of same commodity with same money. Similarly, if the price of a commodity rises, it is equivalent to decrease in income of the consumer as now he has to spend more for buying the same quantity as before. This change in purchasing power due to price change is known as income effect.
   2. Substitution effect- When price of a commodity falls, it becomes relatively cheaper compared to other commodities whose price have not changed. Thus, the consumer tend to consume more of the commodity whose price has fallen, i.e, they tend to substitute that commodity for other commodities which have not become relatively dear.
   3. Law of diminishing marginal utility- It is the basic cause of the law of demand. The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchases in such a manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what the law of demand also states.

   Exceptions to Law of Demand

   The instances where law of demand is not applicable are as follows-

   1. There are certain goods which are purchased mainly for their snob appeal, such as, diamonds, air conditioners, luxury cars, antique paintings, etc. These goods are used as status symbols to display one’s wealth. The more expensive these goods become, more valuable will be they as status symbols and more will be there demand. Thus, such goods are purchased more at higher price and are purchased less at lower prices. Such goods are called as conspicuous goods.
   2. The law of demand is also not applicable in case of giffen goods. Giffen goods are those inferior goods, whose income effect is stronger than substitution effect. These are consumed by poor households as a necessity. For instance, potatoes, animal fat oil, low quality rice, etc. An increase in price of such good increases its demand and a decrease in price of such good decreases its demand.
   3. The law of demand does not apply in case of expectations of change in price of the commodity, i.e, in case of speculation. Consumers tend to purchase less or tend to postpone the purchase if they expect a fall in price of commodity in future. Similarly, they tend to purchase more at high price expecting the prices to increase in future